Capital Budgeting and Political Risk: Empirical Evidence

Abstract:     
This paper surveys and investigates Swedish firms' use of capital budgeting techniques for Foreign Direct Investments. We document that the use of the theoretically correct net present value (NPV) method decreases with the political risk in the host country, and that the use of the Payback method increases with the political risk. We conclude that in the presence of capital market imperfections, unsystematic and country-specific political risks may be important and as they are difficult to estimate (rendering high deliberation costs), managers may be inclined to use simple rules of thumb. This type of behavior might partly explain why surveys find that alternative methods such as the Payback method are frequently used despite their theoretical drawbacks.

Number of Pages in PDF File: 36

Keywords: Capital budgeting, foreign direct investments, political risk, expropriation risk, bounded rationality, deliberation costs

JEL Classification: G31

working papers series